Three business school disciplines--accounting, finance, and real
estate--make use of the capital budgeting concept when teaching project
decision making. Capital budgeting has been defined similarly in each
discipline as, "The process of planning expenditures on assets
whose returns are expected to extend beyond one year."(1) Data used
in capital budgeting analysis are based on cash flows generated from the
projects. In determining these cash flows each discipline utilizes
"only the incremental, or differential, after-tax cash flows that
can be attributed to the proposal being evaluated."(2)

Despite the clarity of these definitions, each discipline appears to
differ markedly over the treatment of debt financing and interest
expense in projecting cash flows for capital decisions. An investigation
of existing texts shows that a number of differences exist in the
treatment of debt for capital budgeting purposes in each discipline.
These variations appear to have developed as a result of the way debt is
considered to fund business projects. The way these inconsistencies
arise in the literature and how these differences may be resolved are
examined here.

The accounting emphasis on the attest function and objectivity leads
to a distinction between recording income for reporting purposes and
using cash-flow information for capital budgeting decisions. Financial
managers who use pricing from a capital asset pricing model (CAPM) are
constrained to separate the investment decision from the methods of
financing in considering capital projects. Real estate professionals
appear to embrace a holistic view of the capital budgeting decision that
incorporates financing and investment issues.

In light of the altogether differing applications of capital
budgeting in accounting, finance, and real estate, it may not be
surprising that each discipline varies in its treatment of debt
financing. What may be significant, however, is the lack of information
in undergraduate business texts on these alternative views. Students
taking courses in finance are unlikely to be aware of the varying uses
of debt financing unless they take additional classes in accounting or
real estate. Similarly, those who major in either accounting or real
estate would have to take course work in areas outside of their
discipline to be exposed to any discrepancies in the use of debt
financing for capital budgeting decisions.

A synopsis of the way interest expense is treated in the capital
budgeting process in finance, accounting, and real estate is presented
in this article. How these differing views may lead to conflicting
capital budgeting decisions is then examined. This investigation
concludes with a summary of how these alternative views may be
reconciled for undergraduate business students.

THE FINANCE VIEW

The finance view treats debt and interest expenses in capital
budgeting as if the projects were 100% equity financed. Consequently,
finance text authors render interest expense as an irrelevant cash flow
in the capital budgeting process. Some finance authors advance the
interest irrelevancy point of view while arguing that any debt financing
on capital projects may be implicitly included in discounted cash flows
(DCF) using the weighted cost of capital. The following examples serve
to illustrate the view of interest expense now prevalent in finance
texts:

We would not subtract the debt proceeds from the required investment,
nor would we recognize interest and principal payments as cash outflows.
We would treat the project as if it were all equity financed.(3)

or

Most firms do use debt and hence finance part of their capital
budgets with debt. Therefore, the question has been raised as to whether
or not interest charges should be reflected in capital budgeting cash
flow analysis. The consensus is that interest charges should not be
dealt with explicitly in capital budgeting--rather, the effects of debt
financing are reflected in the cost of capital which is used to discount
the cash flows. If interest was subtracted, and cash flows were then
discounted, we would be double counting the cost of the debt.(4)

Based on this perspective, a typical capital budgeting problem in
finance would exclude interest expense in computing net cash flow. In
addition, the amount of initial outlay would typically include the total
cost of the asset(s), plus installation costs and training expense,
regardless of how much these costs may have been financed with debt. For
example, if the purchase price of an asset were $12,000, then that would
be the initial outlay used in the capital budgeting analysis,
irrespective of how much was borrowed to finance it.

The rationale for this approach is that it separates the investment
decision from the financing issues related to accepting or rejecting
capital projects. The assumption is that the investment decision is
unaffected by financing arrangements. If the investment appears
attractive, it remains advantageous independent of the way it is funded.
To some extent, the separation of financing from the operational aspects
of capital budgeting decisions rests on the notion that capital
structure is unimportant in the selection of projects.

Table 1 provides an example of how a capital budgeting problem is
formulated in finance. In this illustration, the entire cost of the
asset(s) including installation, training costs, and required net
working capital (NWC) is shown as an initial cash outflow ($26,000). The
method of financing the project does not explicitly enter into the
analysis. Interest expense is not included as an outflow. The discount
rate used in Table 1, however, is based on a weighted average cost of
capital for the firm of 12%, and implicitly uses the after-tax adjusted
component cost of debt. The net present value (NPV) from these cash
flows is $617.19 and the internal rate of return (IRR) is 12.88%. If the
firm's weighted average cost of capital were reduced to 10.275%,
then the NPV would be $1,889. At this rate, the finance view would
produce an NPV equivalent to the one calculated via a real estate
approach TABULAR DATA OMITTED to capital budgeting. At the lower
weighted average cost of capital, the firm's interest rate on new
debt would have to decline to 8.81%. Table 1 assumes that the firm pays
20% of the initial outlay for the project and finances the rest. The
financing issue is not relevant under this method, however, and so
interest expenses are left out of the cash flows and the entire cost of
the project is included in the initial outlay cash flow.

An advantage of the finance methodology is its simplicity. A decision
maker does not have to bother with the financing decision unless and
until the investment project proves viable in terms of yielding a
positive NPV. The operating officers are able to select projects without
having to consider the firm's sources of financing. Once a project
has been selected, the financial manager may then determine the source
of funding that best meets the needs of the firm.

Two potential problems may emerge from separating investment
decisions from financing arrangements. First, contemporary business
choices are made using a team approach that employs accountants as well
as financial managers in the decision-making process. Although
theoretically it may be possible to separate investment, financing, and
reporting aspects of a capital decision, the team management process
requires communication among decision makers. In addition, in light of
the dynamic nature of the investment banking field, the operating
viability of a capital project may hinge on the currently available
financing alternatives, a key feature that may be absent when separating
investment from financing aspects of the capital budget.

Second, the separation of financing from operations assumes that a
firm faces a perfect world where the capital structure of the firm is
immaterial to the capital budgeting process. In other words, the
evaluation of a capital project is independent of the amount of leverage
the firm may acquire in accepting it. As a result, the finance approach
leaves open the question of what discount rate is appropriate for any
particular project. Finance texts are ambiguous on this point. Should
the historical weighted average cost of capital be used or should a
weighted average cost of capital that takes into account the newly
proposed project's financing be utilized? If the firm currently has
no debt, then its historical cost of capital is exactly equal to its
cost of equity. If this same firm is evaluating a new project for which
debt financing is available, should the firm use a discount rate based
on 100% equity, or should it use a (perhaps lower after-tax) rate that
incorporates some debt for the new project? Finance texts such as
Principles of Corporate Finance, fourth edition, by Brealey and Myers,
indicate that, "Borrowing does not affect the risk or the expected
return on the firm's assets, but it does push up the risk of the
common stock and lead the stockholders to demand a correspondingly
higher return."(5)

But are not the stockholders the ultimate decision makers of a firm?
If they require a higher return should not a higher discount rate be
used as more debt is used in the firm's capital structure?
Financial theory recognizes that the leverage of a firm will increase
its riskiness, which at some point will raise the required rate of
return on equity. If a firm embarks on a capital project with borrowed
money, however, the leverage impact on the firm's required return
on equity may not be felt for several years. Therefore, it may be more
appropriate for the full cost of a capital project, in terms of its
financing, to be embedded in the capital budget when it is first being
considered.

THE ACCOUNTING VIEW

The accounting perspective makes a distinction between income for
reporting purposes and cash flows used for capital budgeting.
Consequently, capital budgeting does not employ accrual methods and is
concerned mainly with the cash inflows and outflows of a project as they
occur.(6) Supporting this view is the statement of cash flows
recommended by the Financial Accounting Standards Board (FASB). Among
the purposes of a statement of cash flows are to predict future cash
flows and to evaluate management decisions.(7) The statement shows where
cash was acquired and how it was used. By relating the flows to their
sources, a manager can determine what areas of the company are making a
positive or negative contribution to the organizational goals.

Based on the fundamental purpose of the cash flow statement, the
accounting discipline matches all flows according to their origin. The
result is that interest expense is included in the operating activities
section of the statement of cash flows.(8) For evaluation purposes, any
interest expense resulting from monies borrowed is allocated to the
project funded by such financing activities.

Table 2 illustrates how capital budgeting would conform to the
accounting treatment. The project data for Table 2 is exactly the same
as for Table 1. The firm's TABULAR DATA OMITTED capital structure
is 40% debt and 60% equity. The component cost of equity is 13.6% and
the federal plus state tax rate is 40%. Interest expense is included as
an operating cash outflow, however. The discount rate used is a
market-required rate of return of 16%. Under these circumstances the NPV
is -$4,598 and the IRR is 8.9%. The market discount rate would have to
decline to 6.4875% for the NPV to reach $1,889 and be equivalent to the
value derived via the real estate approach.

Even though interest expense is included in the operating section of
the cash flow statement, accounting texts are silent with respect to the
incorporation of interest expense in capital budgeting cash flows.
Horngren and Harrison,(9) Horngren and Foster,(10) and Moscove and
Wright(11) do not deal with inclusion or exclusion of interest expense
in capital budgeting. Because the FASB has only relatively recently
accorded significance to cash flow accounting, it is not surprising that
the interest expense issue has not yet been incorporated into accounting
texts. However, managerial accounting issues related to cash flow
statements and the financial risks associated with levering firms appear
to highlight the need to address interest expense in capital budgeting
decisions.

Another difference between the accounting and finance perspectives is
in the use of discount rates to evaluate cash flows. The finance
discipline prescribes the use of a weighted average cost of capital for
the entity as a whole to discount the cash flows for each separate
project. The accounting discipline advocates using a rate unique for a
project or a class of projects TABULAR DATA OMITTED rather than the
firm's weighted average cost of capital.(12) In addition,
accounting texts recognize the special financing features individual
projects may have and suggest only subjective methods for incorporating
these factors into the discount rate. For example, Moscove and Wright
state that:

Application of the present value method requires the selection of an
earnings, or cutoff, rate to be used in calculating the present value of
the anticipated cash inflows. No general agreement has been reached
among accountants on how this rate should be arrived at, and no simple
rules can be laid down. The cutoff rate selected tends to be based on
subjective judgment rather than on any mathematical formula.(13)

The accounting approach to interest expense found in the statement of
cash flows offers two advantages. First interest charges are explicitly
included in the evaluation of the firm. The accounting treatment is
consistent with the notion that interest expense is a relevant cash
outflow to the firm from a going-concern standpoint. If the firm levers
itself with debt, it risks insolvency and therefore the financing cost
of the project should be directly recognized from a managerial
accounting perspective. Second, the recognition of interest expense
within a cash flow statement may overcome the problem of estimating the
impact a proposed project's financing will have on the firm's
future cost of capital. The initial inclusion of interest expense in the
capital budgeting cash flow analysis eliminates the need to decide how
financing will affect the cost of capital, because the expense is
already recognized. By including interest expense as a direct cost to
the capital project, a firm may be free to select a discount rate that
will maintain the present capital structure.

The disadvantage of the current accounting approach is that texts
have not dealt with the issue of interest expense in capital budgeting.
The discussion of cash flow statements appears to support the view that
interest expense is a cash outflow that should be included in capital
budgeting decisions. Accounting texts have not as yet, however,
addressed the issue by indicating whether interest expense should or
should not be explicitly incorporated into capital budgeting cash flows.
One apparent reason for this indecisiveness may lie in the way cash flow
information is used within the accounting profession. Current interest
in cash flow accounting is to show the historical position of the firm.
Cash flow statements are used to demonstrate where the company has been
in terms of the generation of income and expenditures from operations.
Cash flows within this limited context are not being used to project the
future advantages of accepting a particular project.

THE REAL ESTATE VIEW

The equivalent procedure in real estate to capital budgeting is
called the DCF model. The definition of the model as given by Wurtzebach
and Miles is:

To bring together, in an analysis, all the factors that affect the
return from a real estate investment. All cash flows are reduced to a
single figure, the present value. These cash flows include all cash
inflows, such as rents and proceeds of sale, and all cash outflows, such
as operating expenses, taxes, and debt service.(14)

It should be noted that not only interest expense but also principal
payments on the funds borrowed to acquire the property are included. In
addition, the initial outlay for an investment does not include the
entire purchase price but only the amount of the actual equity invested.
That is, the initial outlay is the difference between the purchase price
and the amount of the mortgage(s) obtained.(15)

The discount rate used in the real estate view is the after-tax
return required on the equity investment.(16) That is, the rate used to
discount the cash flows is derived from a project only and has nothing
to do with a weighted average cost of capital, as in the finance view.

The basis for the real estate view is the integral role financing
plays in real estate investments. Virtually no real estate investment
takes place in which debt is not used. The procedure used to evaluate
investment decisions explicitly takes this into account by relating the
discount rate to the project and not to the cost of capital.

Table 3 provides an example of the real estate approach to capital
budgeting using the same information contained in Tables 1 and 2. The
initial cash flow represents only those funds invested by the firm in
the project. Since the firm puts 20% down, its initial cash flow
consists of 20% of $12,000 for the building, plus 20% of $8,000 for
equipment. The firm is financed 40% through debt and 60% from equity and
has a federal plus state tax rate of 40%. The analysis includes
depreciation write-offs, principal and loan repayments on the financed
portion of the project, and the interest on the amount of project
financing each year. The firm's NPV is $1,889 and the IRR is
23.75%.

The advantage of the real estate view is that regardless of the
conditions in the capital markets, the capital budgeting process uses
timely inputs. Historical cost of capital may have little effect on
future decisions because these costs do reflect what interest rates may
do over the life of the project. Whatever interest rates are in the
marketplace are the rates used to determine the attractiveness of each
individual project. The real estate view recognizes the impact that
leverage has on project returns by focusing on the portion of the
project being financed and the amount that the firm invests. Because
principal and loan repayments, depreciation, and interest expense are
integral factors of importance to a real estate decision, it is only
appropriate that these items appear in the cash flow statement.

CONCLUSION

It is apparent that the three disciplines of finance, accounting, and
real estate have different perspectives on the process of capital
budgeting. All three have similar definitions and purposes for using
capital budgeting, but the inputs are inconsistent. The finance view
ignores interest expense and the mode of financing of any particular
project. That is, whether a project is funded by all equity or all debt
has no impact on the analysis. The net cash flows are not changed to
reflect financing nor is the discount rate adjusted. The initial outlay
is included as the total cost of a project regardless of whether some or
all of the cost was borrowed.

The accounting view holds interest expense to be a part of operating
activities but does not include them in the cash flows for capital
budgeting purposes. The accounting discipline does not provide any
objective guidance in determining the appropriate discount rate, but
there does appear to be agreement that the rate should be tied to a
project and not to an entity's cost of capital. The accounting view
includes the total cost of the project as an initial outlay the same way
as in finance.

The real estate perspective is more explicit as to how interest
expense should be treated. Real estate decision making includes interest
expense in the cash flows for any given project. Further, the real
estate view maintains that principal payments should also be included.
Real estate differs from both finance and accounting in that only the
equity invested in a project is included when calculating the initial
outlay.

These inconsistencies can easily cause confusion in students trying
to learn the process of capital budgeting. Further, the inconsistencies
may result in different accept or reject decisions depending on which
perspective is used. A consensus on one method should be reached to
present a clear and unambiguous procedure for evaluating investments to
students and practitioners. Presumably the method chosen would represent
the one with the most positive attributes, which means decision quality
would be maximized. Further, one consistent method would make analyzing
the financial condition of enterprises more reliable.

12. Horngren and Foster, 720. See also Raj Aggrawal and Charles
Gibson, "Discounting in Financial Accounting and Reporting: Issues
in the Literature," Financial Executives Research Foundation
(1989): 4.

Ason, Okoruwa, PhD, is an assistant professor of real estate and
finance at the University of Northern Iowa. He received an MBA in
finance from Georgia State University and a PhD in real estate from the
University of Georgia. In addition to teaching, Mr. Okoruwa has provided
real estate consulting services.

Arthur T. Cox, PhD, is an assistant professor of finance at the
University of Northern Iowa. He received an MA in finance as well as a
PhD in insurance from the University of Iowa. He has worked in the real
estate brokerage industry with an emphasis on insurance valuation
issues.

A. Frank Thompson, PhD, is head of the Department of Finance at the
University of Northern iowa. He received a PhD in economics and
actuarial science from the University of Nebraska. In the 1980s Mr.
Thompson served as an AACSB Fellow to the federal government helping to
calculate contingent loss reserves on failed savings and loan assets.

COPYRIGHT 1994 The Appraisal Institute
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